Cash Velocity Summary

Continuing our cash velocity discussion started on March 16, 2007

Cash Velocity Summary

There are two cash velocity rules:
● Make sure that the amount and rate of cash flowing in is enough to cover all your business and personal needs
● Be paranoid. Unfortunately, stuff happens. And unless you’re willing to risk losing your passion, studying and maximizing your cash velocity is essential
The goal of this chapter was to educate the reader about cash velocity -- how to maximize it and how to avoid cash becoming your constraint. We discussed the two drivers of velocity: throughput and cash-to-cash cycle time. We found that by using Goldratt's TOC techniques, we can increase throughput and reduce cash-to-cash cycle time. We also discovered that the velocity of throughput can be more important than the amount of throughput, especially when we are limited by cash.
If fear of cash problems is not enough for you to monitor, forecast and plan for you cash velocity needs, then consider this: The real value of your business is NOT based on your accountant’s value of your assets; it is based on the cash earning stream that your business assets are likely to produce. The more predictable and reliable this stream of cash is, the more valuable your business is. So if you ever plan to sell your business and retire with the money, then you need to pay attention to your cash velocity. Your banker will also value your business and assess your risk based on your cash flow.[1] Cash is still king. It’s still the life blood. So get in the drivers seat by understanding and increasing your cash velocity.

[1] Many banks use the Uniform Credit Analysis® Cash-Flow Worksheet developed by Wells Fargo and made popular by the Risk Management Association.

That completes the cash velocity discussion we started on March 16 for now. What would you like to hear about?

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Increasing Throughput -- Other Considerations

Continuing our cash velocity discussion started on March 16, 2007

Increasing Throughput -- Other Considerations

In previous sections we have covered raw materials and how to reduce them. We also need to cover WIP (Work In Process) and finished goods inventory. DBR Scheduling* reduces WIP by releasing raw materials at the rate at which the constraint can consume the raw materials. Demand Pull* can also be used to reduce finished goods inventory. If we make to stock, or use a replenishment system to supply our customers, then we can minimize the amount of finished goods we carry while at the same time increasing the probability that we will have on hand what is needed. When DBR Scheduling and Demand Pull are implemented, we see a mean reduction in all inventories of about 50%. All of this, of course, helps us to further reduce cash-to-cash cycle time.

* DBR Scheduling and Demand Pull as defined in Goldratt's Theory of Constraints

... to be continued ...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Increase Throughput -- Increase Sales cont.

Continuing our cash velocity discussion started on March 16, 2007

Increase Sales cont.

Last time we ended our discussion with this question: So how do you increase your throughput without going into cash trouble?

The first step is to examine your product mix. Calculate the T/CU for each product. With this information you can devise a strategy to sell more products with higher T/CU and drop those with a lower T/CU. This will allow you to maximize your throughput without investing additional capital or having to tie up more cash in the form of raw material.

Then once again, we must decrease our cash-to-cash cycle time which we have already covered.

... to be continued ...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Increase Throughput -- Increase Sales

Continuing our cash velocity discussion started on March 16, 2007

Increase Sales

Increasing sales is a sure fire way to increase your throughput and is theoretically limitless. My first question is: Are you selling all that you can now? If you are a “make to stock” company, do you ever have the case where you don’t have the product your customer is looking for in stock? If so, you could benefit from DBR Scheduling and Demand Pull to ensure that you always have what your customers demand.

But, let’s say that you have already implemented DBR Scheduling and Demand Pull, and you currently can provide what they want on time. To increase sales you must learn and met your customer’s business NEEDS. New customers are earned over time by understanding the business needs that they have, then customizing your products, services, or policies to meet those needs. In TOC we call this creating a mafia offer. Market Segmentation will be a likely result of matching your offerings with your customers or potential customer’s perception of value. All that being said, sometimes business owners already know that they could earn more business from existing customers or know where that can find new customers. What stops them is cash. To grow sales takes cash and to grow sales a lot takes a lot of cash. So how do you increase your throughput without going into cash trouble?

... to be continued ...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Sales Commission -- Effect on Throughput

Continuing our cash velocity discussion started on March 16, 2007
We last left off on Friday April 6, 2007.

Deceasing sales commission is not necessarily where we want to focus either, but make sure that the commission you’re paying is in alignment with where you’re making your money and/or with the products/services with the highest cash velocity. If you have varying T/CU[1] across your products/services, but you are paying sales people a commission on selling price or gross margin, you may not be motivating them to sell the products that provide the highest throughput for the least amount of your most precious resource. In addition, the traditional way of paying sales people does not take into account the cash velocity either. The ideal commission structure would motivate sales people to sell the highest T/CU combined with the best velocity products/services.

[1] Thoughput per Constraint Unit. This is the amount of money you generate on a sale divided by the amount of your limited resources capacity consumed in order to produce the sale. See Throughput Accounting as part of Goldratt's Theory of Constraints.

... to be continued ...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Increase Throughput to Increase Cash Velocity

Continuing our cash velocity discussion started on March 16, 2007

Increasing Throughput

Throughput (as defined in Goldratt's Theory of Constraints Throughput Accounting) is sales revenue minus truly variable costs. Therefore we can increase your throughput by either 1) increasing sales, 2) increasing our selling prices, or 3) decreasing our truly variable costs.

Let’s start with the last one, first. To decrease our truly variable costs we can:

• Negotiate a lower price with raw material suppliers
  
• Negotiate a lower price with outside services, freight suppliers, or with any other truly variable cost vendors that we have
  
• Decrease the sales commission we pay to our sales people

There is a limit to how much we can reduce our costs. If our costs go to zero, then we are no longer in business. Therefore, we want these costs to be in line, but this is not where we want our focus.

... to be continued ...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

When Offering a Discount Makes Sense

Continuing our cash velocity discussion started on March 16, 2007

Last time (on Friday) we talked about offering a discount to our customers if they paid on delivery.

What kind of discount could you offer to get cash back into your system faster so that you could make more money? Before you answer that question, also consider that 1) you need to be able to sell the additional products so that you can benefit from the faster cycle. If you offer a discount, get the cash back quickly, but don’t have another order, then this strategy is not a good idea for you. 2) If you have other sources for cash, like a line of credit, you may be better off to use that than to use deep discounting. You’ll want to compare the Return on Investment of each. 3) However, if your cash is close to becoming a constraint, and you have no borrowing options, this idea could keep you in business.

A 20% discount for 42 days is an interest rate of 174%. But the cost of money is less important than the availability. Obviously you would not do this if cheaper money was available.

When we have used this type of offer to recover from a cash constraint, we let customers know that it was an offer we were testing to determine customer interest and that it may not be a long-term offering. This will give you the option of discontinuing the offer once you have another source of cash to grow your business.

.... to be continued ...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Increasing Cash Velocity Can Increase Throughput

Continuing our cash velocity discussion started on March 16, 2007

Now let’s look at the impact on what we discussed yesterday had on our throughput.

Let’s say we immediately visit a customer whose complete order was shipped and had just been received by that customer. We make, and they accept, our 20% Discount Mafia Offer and we collect $320 in cash. We pay the sales commission of $40 so we have $280 left. With the $280 we can buy 2 sets of raw materials ($100 each) to produce 2 more products and still have $80 in cash.

We then sell those 2 products with our discount offer collecting $640 ($320 x 2). We pay sales commission of $80 but had $80 in cash from the first offer, so we now have $640 in cash. We buy 6 sets of raw materials and have $40 in cash left. We sell all 6 products with our discount offer collecting $320 x 6 = $1,920. We pay $240 in sales commission leaving $1,920 - $240 + $40 = $1,720 in cash. Let’s go one more time, a 4th cycle. We take the $1,720 in cash and buy 17 sets of raw materials, leaving $20. If we sell all 17 products with our discount offer we collect $320 x 17 = $5,440. We pay sales commission of $680 leaving $4,760, plus the $20 left from the previous cycle, we now have $4,780 in cash.

So, in 53 days you can sell 1 product and generate $260 or you can make a “discount” offer which enables you to sell 17+6+2+1 = 26 products and generate $2,520 in throughput in 52 days.

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Cash Constrained Company Example

Continuing our cash velocity discussion started on March 16, 2007

Reducing Float for the Cash Constrained Company

Now let’s consider a case where there is a cash constraint.

When cash is your constraint, going out of business is usually not far behind. Most small businesses go out of business because they have run into cash trouble. A cash constraint situation can occur to profitable businesses simply because they must pay vendors before they receive their payments – their cash-to-cash cycle times are too long.

Let’s continue with the company who has a cash-to-cash cycle time of 55 days. Because their cycle time is a positive number it means that they must pay their vendors for raw materials before they get paid by their customers. But now, our company has a cash constraint and they can not buy any raw materials. What can be done?

We need to collect enough cash to buy raw materials so we can work our way out of this jam. Consider the impact if we offer a 20% discount on any order paid in full on receipt of goods (a temporary Mafia Offer) . The product sells for $400 but our truly variable costs for this product are only $140. That includes the 10% sales commission. For customers that take the discount, the cash cycle time would be 13 days with throughput of $180 ($400 less $140), almost a velocity of 14! Any customers that pay full price and take the 42 days to pay, their cash to cash cycle time remains at 55 days with throughput of $260 (4.73 velocity). Therefore, we have almost a 4:1 cash cycle if customers take the discount. What a difference!

... to be continued ....

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

The Role of Payment Terms in Cash Velocity

Continuing our cash velocity discussion started on March 16, 2007

The Role of Payment Terms in Cash Velocity

To reduce the time it takes to collect payment from our customers we offer a 1%/10 option, but none of our customers use this option and many of them pay late which is why we have an average of 42 days. So we remain at 55 days.

Thus far we have gone from receiving a net of $300 every 134 days to receiving that same $300 every 55 days. If we were to pay out a 10% sales commission (on selling price) once the customer pays, the net receipt would be $260 every 55 days (assuming continuous sales). More than double the velocity.

Our cash velocity has gone from 1.94 ($260/134 days) to 4.73 ($260/55 days)!

This increase in cash velocity can help you to grow your business. The difference in velocity is 4.73 – 1.94 = 2.79. This means we are getting our cash back more than two times faster than before. We can use this cash to fund additional raw materials and grow our sales and profits.

However, if you reduce your cash-to-cash cycle time but do not have the opportunity to increase your sales, what have you gained? The only bottom-line impact you would have is the reduction of carrying cost and the interest you would now be earning on the cash you are accumulating.

In addition, if you have a cash reserve, you are now in a position to take the discount your vendors are offering. If terms are 2% discount if paid within 10 days or full payment in 30 days, what return would you earn? A 2% return on 20 days is equivalent to 36.5% return over a year. That is a good return, but taking the discount depends on what else you could do with the extra 20 days of money. If your company is growing, and you can use the cash to grow, then you may be able to produce and sell another product in that time. The answer then, depends on your cash position and your goals.

Here's to maximizing YOUR profits!
"Dr Lisa" Lang

(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Goldratt's Theory of Constraints Demand Pull

Continuing our cash velocity discussion started on March 16, 2007
Side Bar for Wednesdays March 21 post:

To minimize the amount of materials we have on hand, we should examine our purchasing policies. Many times we purchase in large quantities to save money. If we purchase in large quantities, we can often receive a quantity discount, and we also can spread the transportation cost over more items. This savings in raw materials and logistical costs are a mirage, because we have to store what we don’t use and we are at risk for inventory obsolescence. If instead, we replenish our materials based on the Demand Pull / Replenishment systems, then we can minimize what we have on hand while ensuring that we have what we need. In addition, our cash position is stronger. We will have only spent/invested what was necessary.

Here's to maximizing YOUR profits!
"Dr Lisa" Lang

Increasing Cash Velocity using Theory of Constraints

Cash velocity is a component of the wider topic of cash flow. Both cash flow and cash velocity are like good health. When you have it, you don’t really notice. But for many companies the time between when they have to pay their vendor and when they get paid is large and getting larger. In many industries customers are pushing out payables to improve their cash positions, thereby reducing yours.

To stay clear of cash troubles we need to understand cash velocity and investigate some strategies to increase it. So let’s jump right in!

Cash velocity is the throughput (T) you generate divided by the time it takes to generate the throughput. Throughputis the selling price of your product/service minus what you paid your vendors (your TVCs[1]) to generate and sell your product/service. The time it takes to generate the throughput is the cash-to-cash cycle time. Cash-to-cash cycle time (CtC) is a ratio that serves to highlight the amount of time a company must finance raw material. It is the time between when you spend money[2] necessary to produce your product or service until you get paid from your customers for the finished goods or services.



You can impact cash velocity by:

• Increasing your throughput
• Decreasing your cash-to-cash cycle time

The rate (or velocity) at which you generate throughput is as important, and at times may be more important than the dollar amount of throughput. Generating $100 of throughput in 30 days, a velocity of 3.33, is much different than generating $80 in 10 days for a velocity of 8. The higher the rate or faster the velocity, the better. For that reason, let’s first focus on decreasing cash-to-cash cycle time.

[1] TVCs are those costs that are incurred because you produced and sold one of your products or services. They include things like raw materials, subcontracted services, freight, sales commission. See Goldratt's Throughput Accounting as developed in Theory of Constraints.
[2] When you pay for your TVCs.

tune in on Monday for more ...

(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Welcome

Welcome to Dr Lisa's Max Profit Zone! We will discuss subjects related to maximizing profitability including Cash Flow, Cash Velocity, Mafia Offers (a Decisive Competitive Advantage), Drum Buffer Rope, Critical Chain, Demand Pull (or Goldratt's Distribuiton Solution), Throughput Accounting, and Goldratt's Theory of Constraints. If you have a question would like to see answered on this blog, please send it to DrLisa@ScienceofBusiness.com